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Look East for Western Market Clues

The major market indexes’ 3-month upward surge stumbled over the past seven trading sessions, but that was a foregone conclusion to people in Australia and Japan. Well perhaps not all who live in those countries knew this, but those who closely trade the currencies of those countries probably knew. Granted they are a microcosmic segment of the populations there, but given how important such signals appear to be, a greater percentage of equities traders around the world ought to pay attention the correlation. See for yourself in the following figure.

This figure represents a comparison between the S&P 500 cash index and the relative price of the Australian dollar compared to the Japanese Yen. As you can see from the chart, the directional movements of these instruments (if not the exact degree of those movements) track very closely. Each of the stock market’s notable turning points matches well with the major turning points in the Australian dollar/Japanese Yen currency pair.

What Does OZ Know?

Why should this correlation exist? It’s a good question and the most readily available explanation may not be definitive. Since the credit crisis of 2008, the Fed substantially lowered rates and removed what was called “the carry trade.” Large institutional investors found that a relatively low-risk way to earn money each day was to use Japanese Yen to buy U.S. dollars in the currency markets. Doing so allowed them to earn interest at an annual rate of 4 percent, because this amount represented the difference between interest rates at the time.

But the landscape has shifted. Now the carry trade is conducted between the Australian Dollar (which pays almost four percent interest) and the Japanese Yen (which pays virtually nothing). This trade, however is more risky than the old US-Yen trade. So when investors feel like they need to reduce exposure to risk, they come out of this trade, weakening the Australian Dollar and strengthening the Japanese Yen.

Okay, But Does It Come with a Fortune Cookie?

Since this trade can help us gauge whether or not investors are comfortable taking risk, it may serve as a useful leading indicator for when the markets are likely to weaken. This indicator would take place in the form of diverging directions; specifically, the stock market would continue higher while the Australian Dollar weakened compared to the Yen. The figure above demonstrates that dynamic.

During the past year that indicator has signaled four times. When the signal occurred (the currency pair fell while the markets rose), the days that followed that signal were marked by the US market falling significantly.

The last three times that fall has come directly after the period of divergence. But when the fall is over with, the pair resumes tracking the U.S. Stock Market. Therefore, when this currency pair begins to trend upward, it’s a good bet that the market will also trend higher.

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